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Intermarket Analysis

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I received a SUBSCRIBER E-MAIL QUESTION that is of possible general interest that I will answer in this space.

SUBSCRIBER E-MAIL:
"What do you see in the Gold sector, and how high can this thing go and does this run up tell you anything about stocks? Also, any comment on a possible reversal hear in the Nas? Make you more cautious or wanting to get into some index puts, especially Nasdaq?"

RESPONSE:
I have been puzzling about gold. It used to be that the precious metals would have one of these major bull markets only if there was prospects of a long-term increasing inflation. This was the dynamic in the 70's. I checked with one of my old UBS buddies, Bernie (Bernard) Savaiko, who has been a gold analyst for a long time and a good one. Bernie is currently the chief economist for the New York Board of Trade. More on his thoughts in a moment.

I was curious as to what is driving this current, or rather, this bull market that began in early-2003 in precious metals, especially gold. Especially since long-term bond rates are not suggesting much of a fear of, or outlook for, an inflation problem over the next few years. Even the 30-year bond has been yielding UNDER 5 percent. We've seen this up to 4.75% recently, but it's a bit under this now. The 10-year T-Note is yielding around 4 and a half percent currently.

Now if gold was reacting to a prospect of inflationary pressures, there is no better 'canary in the mine' to forewarn of this than bond investors. They demand higher yields when there is any prospect that inflation is going to start rising significantly.

If there was a reasonable projection for 5% inflation, bond yields would possible rise to 7-8%. I'm not exactly sure of the 'risk' or inflation premium bonds tend to get over the rate of inflation but I recall 2-3% as a norm. Somewhat consistent with some interpretations I see on long-term patterns in the stock indexes, the current yield structure suggests a perhaps greater risk of a recession out a year or so than there is of a jump in inflation. This because the 'yield curve' is close to inverting.

An inverted yield curve would occur if and when short-term rates (i.e., in 3-6 month T-Bills) were GREATER than long-term bond rates. An inverted yield curve is unusual; AND, has a fairly high degree of correlation with recessionary periods, either current or yet to come.

Of course, 6-month (Treasury) Bills would have to move from its current 4.1% to over 4.5% and this has not happened. And, past 'correlations' are not necessarily predictive of future economic conditions.

My gold analyst friend points to the tremendous rise in wealth we're seeing in China and India, and South East Asia besides. These countries have always valued individual gold ownership as a store of wealth and to hedge against uncertain times. In India, women wore a certain amount the family wealth in the form of gold jewelry. The type of jewelry that is not highly crafted and is valued by weight. Gold content was always typically 18 carat or higher. Anyway, there is a huge rise in wealth in those countries, going to workers and the middle class. And, they are buying a LOT more gold. In addition, there have been some Central Bank increases in gold reserves.

Meanwhile, it's become more costly to extract gold. Environmental costs have been going up too, except in the countries where little heed is paid to the environment. Rising costs are a factor. However, this current bull market in gold is mostly DEMAND driven due to rising wealth in parts of the world where there is both an historic desire to own gold its intrinsic beauty and as hedge against the major uncertainties that are out there.

If American and European investors were buying gold as an inflation hedge, this type of demand can evaporate more quickly than for the long-term demand reasons laid out here. Looking at the principle equities gold sector index, the Philadelphia Gold and Silver Index (symbol: XAU) and on which calls and puts are traded, I offer the following chart:

The most noteworthy technical feature is the well-defined up trendline on the weekly line (close-only) chart from the late-2000 bottom. The last decline to this trend, to around 80 on the XAU Index, was the fourth point on this trendline. Two points, two lows for an up trendline and two highs for a down trendline, are enough to tentatively construct a trendline. THREE points establish the trendline more definitively. The forth point is a 'gift' so to speak; i.e., the decline in XAU to the 80 area and to the support implied by the rising trendline was a great buying opportunity for the stocks and for XAU calls.

The upper parallel line, forming the possible upper end of XAU's uptrend channel, suggests possible resistance coming in around 130. Major resistance and a possible long-range target is to the '96 closing weekly high around 150.

The other noteworthy technical tendency for the gold and silver sector index is the tendency for rallies or downside corrections once the 13-week RSI reaches either the low or high extremes.

This uptrend is pretty prolonged; more than for the overall market. The current bull market didn't begin until 2002-2003. No wonder that Thom Calandra, who used to be featured prominently on CBS/Marketwatch and whom I used to have contact with, became such a big 'gold bug'; I thought he had lost his perspective, but it was I that missed that 'boat'. I was always more enamored of tech stocks and things of the Mind, not of the Earth.

REVERSAL QUESTION:
Upside or downside daily or weekly reversals I define this way. After a move has been underway for some time, often for a prolonged time, there is a substantial new intraday high or low, followed by a close above or below the prior close; e.g., a possible downside reversal is signaled when there's a new high that is followed by a close under the prior day's (or week's) close. A KEY downside reversal is the same only the close is below the prior day's (or week's) LOW.

If we look at the Nasdaq 100 (NDX) Index, which has been the strongest index in the rally of recent weeks, there was neither a downside reversal or a key downside reversal, although the pattern looks like it might have marked a top as there was a spike above the 'line' of prior highs, followed by a close under this line of resistance:

While NDX could be 'building' a top the jury is out as to whether the stalled rally is simply a pause and sideways consolidation only, to be followed by another leg higher consistent with a strong year-end seasonal rally tendency.

I am interested to see whether NDX pierces support implied by its 21-day moving average, at 1675. This may be more telling than the current stalled trend. Not that there arent some other bearish technical aspects; e.g., falling relative strength (a declining trend in the RSI indicator) as prices go sideways. AND, the related S&P 100 (OEX) and the Dow (INDU) have possible double tops that have developed, as highlighted in my Saturday Index Trader's column, a link to which is provided here.

The trend has to be respected and there are no conclusive reversal patterns yet on a technical basis. Adding a close up picture (below) of the above Nas 100 (NDX) chart helps show that the conditions I outline above for downside reversals and 'key' downside reversals were NOT met.

The close yesterday was a substantial new high, but the close was simply back under the prior recent highs where NDX has been finding resistance. We can't conclude that this is not just a result of an 'overbought' that is consolidating its gains by marking time for a while:


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